All 401(k) plans offer specific tax advantages, making them a great way to save for retirement. Contributions to a traditional 401(k) plan, as well as any employer matches and earnings in the account (such as gains, interest or dividends), are considered tax-deferred. This means you won't pay income taxes until you withdraw from the account.
But how exactly do 401(k) taxes work, and how do you pay them? Here are a few rules.
» Use our 401k calculator to see if you're on track for retirement
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Taxes on 401(k) contributions
Are 401(k) contributions tax-deductible?
Contributions to your 401(k) come out of your paycheck before the IRS takes its cut. This is also known as "pre-tax income," and it means two things: 1) you won’t pay income tax on those contributions, and 2) the contributions can reduce your adjusted gross income. If you have an employer match, that money won't be taxed either.
An example of how this works: If you earn $50,000 before taxes and contribute $2,000 of it to your 401(k), that's $2,000 less you'll be taxed on. When you file your tax return, you’d report $48,000 rather than $50,000.
What else should I know about traditional 401(k) contributions?
In 2024, you can contribute up to $23,000 a year to a 401(k) plan. If you're 50 or older, you can contribute up to $30,500.
The annual contribution limit is per person and applies to all of your 401(k) account contributions in total.
You still have to pay some FICA taxes (Medicare and Social Security) on your payroll contributions to a 401(k).
Your employer will send you a W-2 in January that shows how much it paid you during the previous calendar year, as well as how much you contributed to your 401(k) and how much withholding tax you paid.
Taxes on 401(k) withdrawals
What is the tax rate on 401(k) withdrawals?
The money you withdraw (also called a “distribution”) from a traditional 401(k) is taxable as regular income in the year you take the money out.
You can begin withdrawing money from your traditional 401(k) without penalty when you turn 59 ½ — but you still have to pay taxes on the withdrawal because you didn't pay income taxes on it back when you put it in the account. The rate at which your distributions are taxed will depend on which federal tax bracket(s) you're in at the time of your qualified withdrawal.
A few important points:
If you’ve retired, you have to start taking required minimum distributions from your traditional 401(k) account when you're 73.
If you don’t take the required minimum distribution when you’re supposed to, the IRS can assess a penalty of 50% of the amount not distributed.
You can withdraw more than the minimum.
» MORE: Find out which tax bracket you're in
What if you withdraw from your 401(k) early?
For traditional 401(k)s, there are three main consequences of an early withdrawal or cashing out before age 59 ½:
Taxes will be withheld. The IRS generally requires automatic withholding of 20% of a 401(k) early withdrawal for taxes. So, if you withdraw $10,000 from your 401(k) at age 40, you may get only about $8,000.
The IRS will penalize you. If you withdraw money from your 401(k) before you’re 59 ½, the IRS usually assesses a 10% penalty when you file your tax return. That could mean giving the government an additional $1,000 of that $10,000 withdrawal.
You will have less money for retirement, especially if the market is down when you start making withdrawals. That could have long-term consequences.
There are exceptions to the IRS’ penalty for early withdrawals from a traditional 401(k) if you:
Receive the payout over time.
Qualify for a hardship distribution with the plan administrator.
Leave your job and are over a certain age.
Are a survivor of domestic abuse.
Are getting divorced.
Give birth to a child or adopt a child.
Are or become disabled.
Put the money in another retirement account.
Use the money to pay an IRS levy.
Use the money to pay certain medical expenses.
Were a victim of a disaster.
Overcontributed to your 401(k).
Were in the military.
Are terminally ill.
Die.
Finally, a provision in the Secure 2.0 Act now allows special emergency 401(k) distributions of up to $1,000 per year without the 10% penalty. The taxpayer can pay the $1,000 back over a three-year period, and no other distributions can be made in that three-year period until the money is repaid.
» Dive deeper: How 401(k) withdrawals and penalties work
Traditional vs. Roth 401(k) taxes
A Roth 401(k) is funded by post-tax income. This means, unlike a traditional or pre-tax 401(k), your contributions won’t lower your taxable income when you file. Instead, because you'll pay taxes on the money before it goes into your account, you can withdraw the contributions tax-free later. Fidelity, one of the biggest retirement plan providers, says nearly 80% of its plans now have a Roth 401(k) option.
» Learn more about Roth 401(k)s vs. traditional 401(k)s.
What else should I know about Roth 401(k) taxes?
You can begin withdrawing money from your Roth 401(k) without penalty once you’ve held the account for at least five years and you’re at least 59 ½.
You can withdraw contributions from a Roth 401(k) early if you’ve held the account for at least five years and need the money due to disability or death.
Roth 401(k)s no longer require taking RMDs as of January 2024.
A Roth 401(k) might be something to consider if you think you'll be in a higher tax bracket once you reach retirement age.
Compare Roth 401(k) vs. traditional 401(k)
Traditional 401(k) | Roth 401(k) | |
|---|---|---|
Tax treatment of contributions | Contributions are made pre-tax, which reduces your current adjusted gross income. | Contributions are made after taxes, with no effect on current adjusted gross income. Employer matching dollars must go into a pre-tax account and are taxed when distributed. |
Tax treatment of withdrawals | Distributions in retirement are taxed as ordinary income. | No taxes on qualified distributions in retirement. |
Withdrawal rules | Withdrawals of contributions and earnings are taxed. Distributions may be penalized if taken before age 59 ½, unless you meet one of the IRS exceptions. | Withdrawals of contributions and earnings are not taxed as long as the distribution is considered qualified by the IRS: The account has been held for five years or more and the distribution is:
Unlike a Roth IRA, you cannot withdraw contributions any time you choose. |
7 ways to reduce your 401(k) taxes
Wait to withdraw. If you can, consider staying out of your 401(k) account. Withdrawals, especially early ones, can trigger taxes and penalties.
Look for exceptions. If you must make an early withdrawal from a 401(k), see if you qualify for an exception that will help you avoid paying an early withdrawal penalty.
Consider credits. See if you qualify for the saver’s credit on your contributions.
Know the rules about 401(k) rollovers. Rolling a 401(k) account into another 401(k), or into an IRA, usually won’t trigger taxes — if you get the money into the new account within 60 days of when you withdraw the money. Otherwise, the IRS might consider the move a distribution, triggering taxes and maybe even a penalty.
Weigh taking a 401(k) loan vs. a withdrawal. In most circ*mstances, you’ll need to repay the loan within three to five years and make regular payments. And not all 401(k) plans offer loans. Check with your plan administrator for the rules.
Explore tax-loss harvesting. You might be able to offset the taxes on your 401(k) withdrawal by selling underperforming securities at a loss in another investment account you might have. Those losses can offset some or all of the taxes on your 401(k) withdrawal through a strategy called tax-loss harvesting.
See a tax professional. There are other ways to minimize your 401(k) taxes, too. A qualified tax pro can discuss your options with you.
» Dive deeper: View our list of the best rollover IRA providers
